MONETARY EXCHANGE RATE MODEL FOR THE CENTRAL EUROPEAN COUNTRIES - EVIDENCE FROM A PANEL APPROACH

This paper is focused on the issue of empirical congruity of the monetary exchange rate model for the Central European countries with relatively flexible rates. We use quarterly data from 2001 until 2012. The standard flexible-price monetary model is extended to allow for differences in the relative prices of nontradeables. This correction relaxes the assumption about the law of one price - it need not hold for nontradable goods and allows for the Balassa-Samuelson effect. Empirical analysis is divided into two steps. First, using panel cointegration techniques we find evidence of cointegration between the nominal exchange rate and fundamentals implied by the monetary exchange rate model. The signs of estimated long-term coefficients for fundamentals are in line with those implied by the model. Second, the error correction model is used to explore causality. The null hypothesis that the exchange rate fails to Granger-cause fundamentals is rejected for the relative price of nontradables. In addition, the null hypothesis on a lack of reverse causality between relative money and exchange rate is rejected as well. These findings lend support to the monetary model for the Central European countries.